Case — Goodwill

THE QUESTION

Is a taxpayer trying to avoid double taxation by disguising the sale of goodwill as salary?

THE DISPUTE

Taxpayer Says: Any goodwill was attributable to him personally, as key shareholder, and was not part of the sales price. The salary payments reflect economic reality.

Internal Revenue Service Says: The corporate assets were undervalued to avoid double taxation, and the form of the transaction does not reflect its substance.

THE LAW

From Newark Morning Ledger Co. v. United States, 507 U.S. 546, 572-73 (1993): Goodwill is often defined as the expectation of continued patronage by existing customers.

From LaRue v. Commissioner, 37 T.C. 39, 44 (1961): Goodwill is an asset that can be sold with a professional practice.

From Schilbach v. Commissioner, T.C. Memo. 1991-556: A professional practice’s goodwill can attach to both the professional and the business.

From MacDonald v. Commissioner, 3 T.C. 720, 726 (1944): Because there is no specific rule for determining the value of goodwill, we must consider and decide each case in light of its own particular facts.

From Martin Ice Cream Co. v. Commissioner, 110 T.C. 189, 207-08 (1998): There will be no salable goodwill, however, where the business of a corporation depends on the personal relationships of a key individual, unless he transfers his goodwill to the corporation by entering into a covenant not to compete or other agreement so that his relationships become property of the corporation. (See also Norwalk v. Commissioner, T.C. Memo. 1998-279, 1998 WL 430084).

THE CAUSE OF THE DISPUTE

In accounting, goodwill is the difference between the price a buyer pays for your business and the valuation of the individual assets of your business. That difference is an intangible asset, attributable to factors such as the name of the business or its reputation.

When you sell your business, determining who owns the goodwill–you or your corporation–determines the tax treatment. If your C corporation owns the goodwill, you may be doubly-taxed, once at the corporate level as part of the sale, and again when you receive the profits in the form of dividends from your corporation.

Alternatively, in closely held businesses where goodwill typically arises from personal relationships of the individual owner, the goodwill is treated as a personal capital asset of the owner, and qualifies for capital gain rates when sold.

In this case, the taxpayer, who had worked in the insurance business since the 1960’s, was the sole shareholder and president of an insurance-brokerage business that he sold to a bank in 1992. The $20,000 purchase agreement included files, customer lists, insurance agency contracts, the corporate name, corporate goodwill, and a 15-year non-compete provision.

The sale was contingent upon the taxpayer accepting an employment agreement with the bank. Total compensation under the agreement was $600,000 for six years, and consisted of annual wages as well as a deferred benefit. The bank reported the compensation as wages, and paid the required payroll tax, and the taxpayer picked up the income on his personal tax return.

After the sale, the taxpayer worked for the bank in basically the same capacity as when he owned the insurance business. He also kept the corporation active to continue other business.

The IRS audited the corporation’s 2001-2005 tax returns, and determined that the wages the bank paid to the taxpayer under the employment and salary-deferment agreements were actually payments to the corporation for the sale of the insurance business. The IRS says the value of the assets sold should include the annual wages and the deferred compensation, and that the deal was arranged the way it was because the bank wanted to deduct the compensation paid to the taxpayer, and the taxpayer wanted to avoid being taxed twice on the proceeds of the sale–once at the corporate level when the corporation received the purchase-price payments, and then again when he received dividends from the corporation.

The taxpayer says the allocation reflects the economic realities of the transaction, and any goodwill of the business was attributable to him personally. He also says the compensation under the agreement was reasonable because the bank needed him to keep the insurance business going, and he had significant responsibilities after the sale. In addition, he says that instead of focusing on the tax consequences of the transaction, both parties wanted to create an employment relationship and both consistently treated the deal as if they had.

WHAT WOULD YOU DECIDE?

Make your selection, then see “The Court’s Decision” below for a full explanation

For the or for the

THE COURT’S DECISION

HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.

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✓Right answer!

Sorry, wrong answer :(

For the taxpayer. When customers came to the taxpayer’s agency, they came to buy from him–it was his name and his reputation that brought them there. He had no agreement with his corporation at the time of its sale that prevented him from taking his relationships, reputation, and skill elsewhere, which was precisely what he did when he began working for the bank. In light of the taxpayer’s personal relationships, his experience in running all facets of an insurance agency, and his responsibilities as manager of the bank’s agency, we find that the compensation the bank paid him was reasonable. We are satisfied the taxpayer and the bank were genuinely interested in creating an employment relationship. Payments to the taxpayer were not disguised purchase price payments to his corporation. (Editorial note: This case contains several other issues not discussed here.)